Implementation and performance of interest-free banking in Pakistan

Interest was eliminated from banking in Pakistan in its attempt to move its economy into conformity with Islamic religious beliefs. Interest-free banking coexisted with traditional banking from 1981 to 1985, and supplanted the latter effective July 1985.;The central bank, Pakistan Banking Council, and commercial banks implemented and operationalized the new system, which differed in time frame and content from the Council of Islamic Ideology's blueprint. Implementation was gradual to avoid destabilization.;There are few empirical studies of an interest-free banking system. This dissertation evaluates the successfulness of interest-free banking by examining and comparing the performance of interest-free banking in Pakistan in terms of sources and uses of funds, profitability, and rates of return on deposits and finance, in the pre-transitional, transitional, and post-transitional periods, at an aggregate level, and at a disaggregated level involving two groups, the nationalized commercial banks and selected foreign banks. The process of implementation of interest-free banking is also examined, and central bank policy is studied. The analysis is placed in a macroeconomic perspective of the three periods, and the legal framework of money and banking.;Law and practice of interest-free banking are characterized by cautiousness. Mark-up finance was liberally permitted and overwhelmingly adopted. Banks added a buy-back feature that is considered unIslamic. Their profit and loss sharing finance is insignificant.;The selected foreign banks outperformed the nationalized commercial banks. Their deposits grew at rising rates, while the NCBs' growth rates fell sharply. Their loan growth rate for the interest-free period was higher than for the interest-based period, and twice the NCBs' loan growth rate. Their profits increased at several times the growth rate of the NCBs' profits, and they paid mostly higher rates on their PLS deposits. Other indicators of profitablity (such as return on assets and equity) are also better for these banks in the interest-free period. The NCBs have large loan defaults and high personnel costs relative to deposits, and performed relatively worse in the interest-free period than in the interest-based period.